The timing of fiscal interventions: Don’t do tomorrow what you can do today
Karel Mertens Morten O. Ravn
Karel Mertens Morten O. Ravn
The composition and timing of the fiscal stimulus is a major concern for policymakers. This column presents research showing that anticipated tax cuts result in reduced economy activity before they take effect. During the current downturn, that constitutes a strong argument against stimulus policies that phase in tax cuts over time.
The current macroeconomic downturn has sparked repeated calls for fiscal stimuli to combat the ensuing decline in activity and labour market conditions (e.g. Blanchard and Cottarelli 2008; Corsetti 2008; Krugman 2008). Common to the proponents of a fiscal intervention has been the appeal for the immediate use of fiscal levers. The prime reasons for this are the fact that the current downturn has been unusually deep (and probably associated with tightening financial constraints) and the view that fiscal policy changes have their fullest effect on the economy only with a considerable delay. Procrastination therefore runs the risk of stimulating the economy when it – we hope – is already recovering.
Anticipation of tax changes
But, there are other aspects of procrastination that also may matter. Not only may a delay in the application of fiscal measures end up stimulating a recovering economy, but anticipation effects may actually depress the economy until the fiscal changes are implemented. Anticipation effects arise when policy makers announce – or legislate – future fiscal interventions. This phenomenon is quite common as far as tax changes are concerned. Tax laws often contain pre-announced changes in future tax rates because of phase-ins and due to the not so infrequent use of sunsets associated with temporary tax changes.
To the layperson, it would seem obvious that the announcement of a low future price of a good may delay its purchase. A supermarket wishing to sell beer today at good profit margins would probably be ill advised to announce a reduction in the price of beer next week. Such principles of forward-looking behaviour and intertemporal choice are deeply rooted in much of macroeconomic theory and apply also to the impact of tax changes (see Hall, 1971, for an early example of the impact of pre-announced tax changes). Yet, empirical investigations have failed to purport the idea that anticipated tax changes affect current choices. Indeed, a number of studies of consumption behaviour have indicated that consumption appears to react little to announcements of future changes in taxes and that consumption does adjust to the implementation of tax changes that were known in advance.
Some economists have concluded on this basis that a substantial fraction of households are liquidity-constrained (or fail to be able to make simple forward-looking decisions). In a provocative and influential piece, Mankiw (2000) argues that perhaps up to half of US households may be described as rule-of-thumb consumers that simply consume their current income due to the presence of binding liquidity constraints. For that reason, the fact that tax changes may often be pre-announced matters little – the tax changes simply affect the economy when they are implemented.
Procrastination: Does it matter?
Nonetheless, while there is little evidence that consumption choices are affected by announcements of future changes in taxes, other key macroeconomic aggregates do react to such policy announcements. Figure 1 shows the dynamics of aggregate output, consumption, investment, and hours worked following announcements of changes in tax liabilities six quarters in the future, which we estimate for the US post-1945 (Mertens and Ravn 2009). The vertical scale show percentage deviations from trend and the size of the change in taxes is normalised to one percent tax liability cut relative to GDP. The announcement dates correspond to the dates at which tax laws were signed by the president relative to the implementation dates stated in the tax legislations.
Figure 1. The response of output, consumption, investment, and labour to announced tax changes
The figure makes it clear that pre-announced tax changes cause important adjustments in aggregate activity, hours worked, and investment. Announcing a cut in taxes six quarters out leads to a steep drop in aggregate investment, a decline in aggregate output, and a gradual slide in hours worked. Once the tax cut is implemented, each indicator recovers and peak responses are reached about 2-2.5 years thereafter. Thus, while aggregate consumption appears relatively insensitive to announcements of future tax changes, this is certainly not shared by other main macroeconomic indicators. This evidence challenges the view that lack of consumption responses to anticipated tax changes is evidence for rule-of-thumb behaviour or the absence of forward-looking economic agents.
To take one example, the Reagan tax cut of 1981 (the Economic Recovery Tax Act of 1981) introduced new depreciation guidelines and major cuts in personal marginal income tax rates and corporate tax rates. Signed by President Reagan in August 1981, it included changes in taxes that were phased-in from August 1981 until the first quarter of 1984. In fact, the largest change in tax liabilities was the cut of more than $57 billion in 1983, dwarfing the $9 billion tax liability cut of 1981. Therefore, the Economic Recovery Tax Act of 1981 was associated with major anticipation effects. According to our estimates, these expectations of future tax cuts actually contributed to the recessionary impact of the Volcker disinflation that took its course during the early 1980s. Once the economy was back on track in the mid-1980s, the tax cuts were being implemented and therefore further stimulated the uptake in aggregate activity.
Relying on news effects
So, if this evidence is correct, why do policy makers use phased-in policies, temporary tax changes, and other means of tax changes that introduce anticipation effects? After all, Reagan probably did not intend to deepen the early 1980s recession. Potential reasons likely include concerns about government debt or a desire that economic policy appear predictable rather than haphazard so that households and firms can adjust to changes in taxes (even if some theories of optimal taxes call for the opposite), and one can even write down theories that call for gradual changes in taxes.
Another potential reason is the idea that current good news about future economic fundamentals stimulates current activity. Such news effects, if true, would imply that the promise of future tax cuts lead to an uptake in activity even before they are implemented. If this was true, then you can almost “eat your cake and have it too” as the pre-implementation boom that should follow the announcement of future lower taxes would lower government debt through higher tax revenues and therefore help paving the way for a cut in taxes without having to cut spending (at least partially).
The evidence presented here suggests that there may be good reasons for phasing-in tax changes – relying on news effects, however, does not seem to be one of them. Thus, in the present environment, a good advice to governments is that the use of phased-in tax policies, temporary tax cuts, and other tax policies associated with anticipation effects should be used with great care.
Whether the same also holds true for changes in government spending is another question that is still not clear.
Blanchard, Olivier and Carlo Cottarelli (2008), "IMF Spells Out Need for Global Fiscal Stimulus", interview in IMF Survey magazine, 29 December.
Corsetti, Giancarlo (2008), “The rediscovery of fiscal policy?” VoxEU.org, 11 February. Hall, Robert E. (1971), “The Dynamic Effects of Fiscal Policy in an Economy with Foresight”, Review of Economic Studies 38, 229-44.
Krugman, Paul R. (2008), “Optimal Fiscal Policy in a Liquidity Trap”, Princeton University mimeo.
Mankiw, N. Gregory (2000), “The Savers-Spenders Theory of Fiscal Policy”, American Economic Review 90(2), 120-25.
Mertens, Karel and Morten O. Ravn (2009), “Empirical Evidence on the Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks”, CEPR Discussion Paper no. 7370.This article may be reproduced with appropriate attribution. See Copyright (below).